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Balancing MBS and corporate debt

| November 9, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The MBS and corporate debt markets have both widened to the Treasury curve this year for different reasons with spreads between the two sectors lately sitting at the narrow end of the range. Both sectors look likely to widen through 2019, with MBS set to turn in the better performance.

Exhibit 1: MBS and corporate debt spreads stand at their widest levels of 2018

Source: Bloomberg

Both MBS and corporate debt have had the Fed working against them this year. Steadily higher fed funds have had some marginal effect on carry, but steadily lower market liquidity is likely more important. Higher rates and the reversal in QE both have taken cash out of the system. Excess reserves at US banks since October 2017 have dropped by $382 billion. Any drawdown in cash should drive up the value of other liquid, safe assets including Treasury debt. All else equal, all spreads to the Treasury curve should widen with the magnitude depending on relative sector liquidity. The corporate market felt the sharp effect of falling liquidity early this year as repatriation of corporate cash took investors out of the front end of the corporate curve. The Fed has been following up steadily.

The corporate debt market has also seen a steady rise in balance sheet leverage for several years and increasing concentration in ‘BBB’ debt. Today’s ‘BBB’ debt may or may not be weaker than past versions, but ‘BBB’ debt almost indisputably makes the corporate market more vulnerable to any economic slowdown. The Fed’s path has raised reasonable concerns about the pace of growth over the next few years, and the current nearly $3 trillion in ‘BBB’ could disrupt spreads across fixed income if concerns about growth became concerns about recession. Not only do spreads widen sharply as an issuer potentially slides below ‘BBB’, but the issuer loses access to the prime commercial paper markets, making balance sheet liquidity management harder. A rising probability of challenges for ‘BBB’ debt should steepen spreads between safer and riskier debt, a trend that has started this year. If economic growth moderates next year as many economists expect, concern about corporate credit is only likely to grow. Corporate risk is likely to drive the market next year.

MBS actually benefitted early this year from its liquidity relative to corporate debt and other sectors. Correlations between MBS and corporate spreads and anecdotal evidence pointed to a reallocation into MBS. MBS spreads went sideways from February through June and the spread between corporates and MBS widened. MBS spreads have underperformed corporates’ since then.

Lately a familiar set of arguments have come out to explain weaker MBS spreads: the Fed’s steady withdrawal from QE, the slow erosion of TBA quality without the Fed filtering out the worst pools, steady net supply from originations, no clear signal of the next marginal buyer. Those concerns have shaped market expectations since at least early 2017 as the Fed laid out its QE exit strategy, but only since September have spreads seemed to steadily widen. That calls into question the case for these influences, or at least their magnitude. Maybe something about the market since September has finally triggered them—the wolf arriving long after the cry went out—but the thing isn’t obvious.

Exhibit 2: Net YTD supply in agency fixed-rate MBS

Source: eMBS

The simplest theory of spreads seems to be one centered on the rising fundamental risk in corporate debt. If growth moderates, the market should price a rising probability of problems with ‘BBB.’ That’s an issue big enough to drive market spreads wider and the credit spread curve steeper. If the problem becomes big enough, wider corporate spreads would also tighten financial conditions and possibly change the Fed’s path, too.

The relative advantage that MBS does have is liquidity and safety. The nominal average spread on investment grade corporate debt now stands at 106 bp, the nominal spread of par 30-year MBS to the 7.5-year Treasury stands at 96 bp. That 10 bp spread is at the 22nd percentile of the range over the last five years. Wait for corporate spreads to widen faster than MBS from here.

* * *

The view in rates

The strategy of buying the 10-year as yields rise beyond 3.15% and selling as yields drop below 2.85% still looks sound. With 10-year yield closing lately near 3.18%, duration looks like a modest buy. The curve still looks set to flatten. Look for the Fed to hike through most of 2019. Despite higher rates in the front end, the back end will still tend to price to 2% inflation and somewhere between 1% and 1.3% real rates.

The view in spreads

The corporate market has become the primary driver of spreads, and the trend looks wider with a steeper spread curve. Continued addition of leverage makes investment grade corporate debt riskier, and potential softening in GDP growth in the second half of this year only raises concerns. A drift wider in corporate spreads would should pull agency MBS and other products along with it, although agency MBS would still likely benefit from investor interest in liquidity.

The view in credit

While the fundamentals of corporate balance sheets have some weak spots, they are harder to find on consumer balance sheets. Median household income is at a record along with household net worth, and household debt costs as a percent of disposable income are near a record low. If there is weakness, it’s in households with sizable student debt, and rising delinquencies in that asset signal that the debt is weighing heavily.

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